Get out or hedge risk via derivatives – P2/3

For investors, risk management is almost as important and growth of investments. Without a well-rounded risk management strategy, your investments are exposed completely. This is true not only for financial assets but also for cryptocurrencies.

In this 2nd part of the series, we will cover the most extreme risk-management measure, getting out and the most common way of hedging risks in traditional financial markets, via derivatives.

Strategy 1: Get Out

One of the notions that we often hear is that cryptocurrency resembles the “dot com bubble” of the early 2000s. Needless to say, some financial experts believe that the cryptocurrency bubble will burst (even further) soon.

The bursting of the “dot com bubble” was marked by the staggering crash of the Nasdaq Composite stock market index between 2000 and 2002. The index took nearly fifteen years to recover from this plunge.

The Benefit

Just as no one could have predicted the crash of 2000 or that of 2007, no one can predict where the price of cryptocurrencies will be three months from now, let alone five years from now. The safest and most extreme method to reduce your risk in such an uncertain market is to get out completely and hence eliminate all risk.

Needless to say, this extreme safety also has an extreme flip side. Just as you save yourself from any loss whatsoever, you also sacrifice all potential gains you could have made if you had stayed in the market and the prices had gone up.

No loss. No gain.

The challenge

So, getting out too early is not the smartest way to go. It is important to time your sell so that you don’t miss out on all the gains that the market has to offer. Timing the sell not as easy as it seems. Look at it this way. In the last eight years, the crypto market has seen quite a few declines. In fact, the plunge of early 2018 ranks 4th in severity, percentage-wise. Obviously, volatility in the cryptocurrency market is not a new thing and selling too early to avoid a big loss is a very real possibility.

Strategy 2: Derivatives as a Risk Management Tool

One of the easiest ways of conceptualizing hedging is to think of it a type of insurance. Think of it like buying fire insurance for your home. You pay a small fee to purchase the insurance and hedge your home from financial losses that may potentially occur due to fire.

Investments, whether in financial assets or in cryptocurrencies, are bound to see downturns. Hedging via derivatives is one way to ensure (partially or completely) yourself from a negative outcome, thus reducing your losses.

So, how does this fire insurance for your financial investments work? In financial markets, one way to hedge your investments is through Derivatives. Options and futures are the most common derivative instruments normally available. It is important to note, though, that these may not be available to smaller investors, the Price Takers.

The Benefits of Hedging

The best way to explain the benefits is to demonstrate it through an example. The premise, of course, is that you are convinced of Satoshi’s long-term vision, but you are also wary of the price volatility after witnessing the ups-and-downs in the last few years. You want to do something to ensure yourself against this volatility.

To protect yourself from a fall in the price of the Bitcoin, you buy a “Put Option”, a derivative. This put option gives you the right to sell the Bitcoin at a pre-determined price, say $10,000 per Bitcoin in one year. This pre-determined price is called the “Strike Price”. Now, imagine that the price of the Bitcoin falls to $1,000 a few months after you bought the put option. You can sell your put option and cover your losses by the gains made from this sale. But, imagine that the price of the Bitcoin jumps up to $30,000. You are still covered because now you can let go of your put options and enjoy the price appreciation in the Bitcoin.

The Catch

Derivatives aren’t cheap

As you well know, there’s no such thing as a free lunch. Especially when it comes to derivatives. The more exotic and difficult-to-liquidate the asset, like cryptocurrencies, lesser the transparency in the pricing of the derivatives. The lack of consistency in the pricing of derivatives is one of the reasons why they are the biggest money makers for financial institutions around the world. For example, the price of put options on Bitcoins could easily range from 20 % to 30% of the value of the Bitcoin itself.

Underwriters are a risk

The success of financial hedging using derivatives rests on the fact that when the options are exercised, or used, the underwriter (the one who sold you the options) is honorable enough, and has enough assets on their balance sheet to actually pay up. Unfortunately, cryptocurrency is largely unregulated. This leads to an abundance of shady players in this space. If an underwriter refuses to honor a put option that you bought, there is not much that you as a Price Taker can do about it.

Derivatives are probably an overkill for HODLers

Most buy-and-hold investors ignore short term price fluctuation altogether, but most hedging options are short-term in nature. It is rare to find someone selling 10-year put options for Bitcoins. Which means that most cryptocurrency HODLers will not trade a derivative contract (not for hedging purposes at least) in their life.

So, for cryptocurrency HODLers, hedging is not really a great risk management tool due to the costs as well as often it is hard to find the exact hedging structure needed.

Next time

We have shared a couple of risk management strategies with you here. There are many more ways in which you can protect yourself from copping big losses when the price of cryptocurrencies sees a sudden drop. There are a couple more strategies that we’d like to share with you. Until next time.